Losses and Loss Limitations. Solutions to Problem Materials

CHAPTER 5 LOSSES AND LOSS LIMITATIONS SOLUTIONS TO PROBLEM MATERIALS Question/ Problem 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 Status: Present Edition Topic Bad debts: business Bad debts: tax benefit rule Bad debt and § 1244 stock Ethics problem § 1244 stock Issue recognition Casualty loss: $100 and 10% of AGI floors Casualty loss: disaster area loss Issue recognition Casualty loss: insurance recovery At-risk rules At-risk rules Issue recognition At-risk rules Passive activity loss rules: general application Passive activity loss rules: general application Passive loss rules: general application Sale of passive activity and suspended losses Sale of passive activity Passive losses of personal service corporation Passive losses of corporation Passive, active, portfolio income of non-PSC Groupings of two types of businesses Issue recognition Interaction of at-risk and passive loss rules Interaction of at risk and passive loss rules Interaction of at-risk and passive loss rules 5-1 Unchanged Unchanged New New Unchanged Unchanged Modified Unchanged Unchanged Modified New Unchanged Unchanged Modified Unchanged New Unchanged Modified Unchanged Unchanged Unchanged Unchanged New Unchanged Unchanged New Unchanged Q/P in Prior Edition 1 2 4 5 6 7 8 9 12 13 14 15 23 17 18 19 20 21 24 25 27 5-2 Problem 28 29 30 31 32 33 34 35 36 37 38 Topic Edition Edition Interaction of at-risk and passive loss rules Issue recognition Passive loss deduction and at-risk amounts Rental loss: active participation Active income and passive income: real estate activities Ethics problem Material participation in real property trades or businesses Real estate rental exception Ethics problem Passive activity loss allowed, suspended losses and credits Rental real estate loss deduction Unchanged Unchanged Unchanged Unchanged New 28 29 30 31 Unchanged Unchanged 33 34 Unchanged New Unchanged 35 Unchanged 38 Casualty loss Offsetting rent income by passive losses Application of material participation activity rules Internet activity Internet activity Unchanged New Unchanged 1 Unchanged Unchanged 4 5 37 Research Problem 1 2 3 4 5 2 PROBLEM MATERIAL 1. Smith, Raabe, and Maloney, CPAs 5101 Madison Road Cincinnati, Ohio 45227 January 29, 2000 Loon Finance Company 100 Tyler Lane Erie, Pennsylvania 16563 Dear Sir: This letter is to inform you of the possibility of taking a bad debt deduction of $8,000. Your loan to Scott is a business bad debt; therefore, you are allowed to take a bad debt deduction for partial worthlessness. You also may be able to take a bad debt deduction in the year when there has been a final settlement on the debt if you collect less than currently expected. Alternatively, if you deduct any amount as a bad debt this year and subsequently collect on the debt, you may recognize income in the year the bad debt is collected. Should you need more information or need to clarify anything, please contact me. Losses and Loss Limitations 5-3 Sincerely, John J. Jones, CPA Partner TAX FILE MEMORANDUM Date: January 29, 2000 From: John J. Jones Subject: Bad Debt Deduction for Loon Finance Company Loon Finance Company’s $20,000 loan to Scott is a business bad debt. Therefore, a bad debt deduction is allowed for partial worthlessness of $8,000 (i.e., Scott has filed for bankruptcy and Loon has been notified that the most it can expect to receive is 60 cents on the dollar). Loon will be able to claim a bad debt deduction in the year when a final settlement has been reached with respect to the loan if less is collected than is currently expected. If more is collected, Loon may have gross income. pp. 5-3 and 5-4 2. In 1999, Tom has a bad debt of $4,000. Because this is a nonbusiness bad debt, it is treated as a short-term capital loss. As such, Tom can use only $3,000 of the loss to offset ordinary income in 1999. In 2000, the collection of the debt increases Tom’s gross income. However, only $3,000 of the $4,000 received by Tom is included in his gross income in 2000 because this is the amount which produced a tax benefit in 1999. pp. 5-3 and 5-4 3. Salary § 1244 ordinary loss (limited to $100,000) Short-term capital gain on § 1244 stock Short-term capital loss (nonbusiness bad debt) Net short-term capital gain Long-term capital loss [excess of § 1244 loss ($110,000 - $100,000)] Net long-term capital loss Capital loss limitation Adjusted gross income pp. 5-5 and 5-6 $12,000 ( 7,000) $ 5,000 (10,000) ($ 5,000) $150,000 (100,000) ( 3,000) $47,000 5-4 4. Year of Deduction for Worthless Securities (page 7-9). The issues raised are whether the stock has become worthless, and, if worthless, the year it became worthless. Determinations of whether a security has become worthless and the year of worthlessness are questions of fact, and the burden of proof is upon the taxpayer. Generally, an adjudication of bankruptcy is proof of worthlessness and hence, the loss on the stock should be taken in the year of the adjudication. In this situation, the fact that Jack was not aware of bankruptcy is not controlling. Jack should not claim the loss on the current year’s return. Rather, he should file an amended return for the year the stock became worthless. Jack may not claim the loss in the year most advantageous to him. He must deduct it in the year when all the facts point to its actual worthlessness. 5. Sell all of the stock in the current year: Current year’s AGI Salary Ordinary loss (§ 1244 limit) Long-term capital gain Long-term capital loss ($80,000 - $50,000) Long-term capital loss (limit) AGI Next year’s AGI Salary Long-term capital gain Long-term capital loss carryover ($30,000 - $11,000) Long-term capital loss (limit) AGI Total AGI Current year Next year Total $8,000 (30,000) $10,000 (19,000) $80,000 (50,000) ( 3,000) $27,000 $90,000 ( 3,000) $87,000 $ 27,000 87,000 $114,000 Sell half of the stock this year and half next year: Current year’s AGI Salary Ordinary loss (§ 1244 stock) Long-term capital gain AGI $80,000 (40,000) 8,000 $48,000 Next year’s AGI Salary Ordinary loss (§ 1244 stock) Long-term capital gain AGI $90,000 (40,000) 10,000 $60,000 Losses and Loss Limitations Total AGI Current year Next year Total 5-5 $ 48,000 60,000 $108,000 Mary’s combined AGI for the two years is lower if she sells half of her § 1244 stock this year and half next year. p. 5-6 6. John should be concerned with the following tax issues: • Was there a bona fide debt? • Business bad debt. • Nonbusiness bad debt. • John’s basis in the debt. • Date of worthlessness. • Classification as capital or ordinary. • Was there a § 1244 loss? • Date of worthlessness. • Amount of worthlessness. • Classification as capital or ordinary. pp. 5-3 and 5-4 7. Home ($300,000 - $175,000) - $100,000 = $25,000 loss Antique clock ($2,000 - $1,500) = $500 gain Antique table ($3,000 - $3,000) = $0 Antique organ ($20,000 - $5,000) = $15,000 gain Casualty loss ($25,000 - $100 floor) Less: Casualty gain ($15,000 + $500) Excess of casualty loss over gain Less: 10% of AGI floor ($100,000 X 10%) Casualty loss deduction from AGI $24,900 (15,500) $ 9,400 (10,000) $ -0- pp. 5-7 to 5-12 8. The loss is a business loss. Therefore, for the farm building and the farm equipment that were completely destroyed, the adjusted basis is used in calculating the amount of the casualty loss. For the barn that was damaged, the lower of the adjusted basis or the decline in value is used in calculating the amount of the casualty. Building ($80,000 - $60,000) Equipment ($40,000 - $25,000) Barn ($30,000 - $25,000) Total loss $20,000 15,000 5,000 $40,000 5-6 Because the President declared the area a disaster area, Grackle could claim the loss on last year's return or on the current year's tax return. If Grackle applies the loss to the prior year, the benefit of the loss will be at lower tax rates. If the loss is applied to the current year, the benefit will be at a tax rate of 39% and thus, provide a tax savings of $15,600 ($40,000 X 39%) rather than $11,350 [($15,000 X 34%) + (25,000 X 25%)]. Grackle should include the loss on the current year's tax return, since the tax savings is $4,250 ($15,600 - $11,350) greater. pp. 5-7 to 5-12 9. The tax issues for Toucan Corporation are as follows. • Is this a casualty loss? • What is the amount of the loss? • The basis for computing the loss. • The decline in fair market value. • Replacement cost. pp. 5-7 to 5-12 10. Smith, Raabe, and Maloney, CPAs 5101 Madison Road Cincinnati, Ohio 45227 January 26, 2000 Snipe Industries 450 Colonel’s Way Warrensburg, MO 64093 Gentlemen: This letter is to inform you of the tax consequences of filing a claim versus not filing a claim with your insurance company for reimbursement for damages to the car driven by Sam Smith. Because the claim is being made by a company and not an individual, you may deduct the casualty loss in full even if no claim for insurance is filed. Thus, your plan will work. The full $7,000 loss is deductible. Note that the result would have been different if the casualty loss were claimed by an individual. In such a circumstance, because the car was insured, the amount of the tax deduction would be determined as if a claim had been filed with the insurance company and the reimbursement was received. Consequently, the deduction would have been zero. The benefit of filing the claim, absent any tax consequences, is an expected cash inflow of $6,000 from the insurance company, while the tax savings from the casualty loss deduction Losses and Loss Limitations if no claim is made is $2,380 (assuming a 34% tax rate). Thus, the expected cost of policy cancellation should be at least $3,620 ($6,000 - $2,380) to justify not filing a claim. Should you need more information or need to clarify anything, please contact me. Sincerely, John J. Jones, CPA Partner pp. 5-7 to 5-12 11. The at-risk rules limit Fred’s deductions. He can deduct $35,000 in 1999, and his at-risk amount will be reduced to $15,000 ($50,000 - $35,000 deducted). He will be limited to a $15,000 deduction in 2000 unless he increases his amount at risk. For example, if Fred invests an additional $10,000 in 2000, his at-risk amount would be $25,000 ($15,000 balance + $10,000 additional investment), and he would be able to deduct the entire loss in 2000. pp. 5-18 and 5-19 12. Smith, Raabe, and Maloney CPAs 5101 Madison Road Cincinnati, Ohio 45227 February 5, 2000 Mr. Bill Parker 54 Oak Drive St. Paul, MN 55162 Dear Mr. Parker: This letter is in response to your inquiry regarding the tax treatment of losses that you could expect this year and next year from an investment in Best Choice Partnership. As I understand the facts, you would invest $60,000 in the partnership with the expectation that your share of the partnership losses in the current and succeeding years would be $40,000 and $25,000, respectively. Even though your investment would not be subject to the passive activity limitations, the amount of the deduction that you may claim in any one year is subject to the at-risk rules. Essentially, these rules provide that your deductions are limited to the amount that you have invested in the venture or the amount that you could lose if the investment were to be unsuccessful. Consequently, in your case, the initial amount that you would have at risk would be $60,000. Therefore, you would be able to deduct $40,000 in the current year, which would cause your at-risk basis to be lowered to $20,000 ($60,000 - $40,000). Because your at-risk basis at the end of next year would be only $20,000, your share of the partnership loss that would be deductible would be limited to $20,000. The amount not deducted under this scenario would be deductible later when your at-risk basis increases, for example by additional investments you may make in the partnership or because of income generated by the partnership. 5-7 5-8 If you have additional questions or need further clarification, please call me. Sincerely, John J. Jones, CPA pp. 5-18 and 5-19 13. Application of the at-risk rules: • What is their at-risk basis and does it include their share of the entity-level borrowing? • What amount of the partnership’s loss will George and Susie be able to deduct in the current year and what amount (if any) will be suspended because of the at-risk rules? Application of the passive activity rules: • Whether the investment is a passive activity or whether George and Susie are treated as material participants in the venture. • If the passive activity rules apply, what amount may be deducted in the current year and what amount is suspended under the passive loss rules for future use? • What is the interaction between the at-risk rules and the passive activity rules in determining the current treatment of losses flowing from the investment? pp. 5-17 to 5-22 14. Based on the following, Alternative 2's benefit exceeds Alternative 1's by $1,913 ($54,906 - $52,993), primarily because of the flow of the benefits and the effect of the at-risk rules on those benefits. Alternative 1 Income Tax cost/ benefit After-tax benefit 8% PV factor Present value Yr. 1 ($24,000) Yr. 2 (24,000) Yr. 3 72,000 Total present value $ 6,720 1 4,480 2 (17,920) $ 6,720 4,480 54,080 0.92593 0.85734 0.79383 $ 6,222 3,841 42,930 $52,993 Tax cost/ benefit After-tax benefit 8% PV factor Present value $11,200 25,280 28,800 0.92593 0.85734 0.79383 $10,370 21,674 22,862 $54,906 Alternative 2 Income Yr. 1 ($48,000) Yr. 2 32,000 Yr. 3 40,000 Total present value 1 $11,200 (6,720) 11,200 3 4 Because of the at-risk rules, Amanda's tax deduction in year 2 is limited to her remaining at-risk basis of $16,000. The $8,000 loss that is not deductible in year 2 is Losses and Loss Limitations 5-9 suspended until her at-risk basis increases. Therefore, her tax benefit from the deduction is $4,480 ($16,000 X 28%). 2 Amanda's $72,000 share of income increases her at-risk basis and provides the opportunity to claim the $8,000 suspended loss from the previous year. Therefore, her taxable income for year 3 from this investment is $64,000 ($72,000 - $8,000) and the tax is $17,920 ($64,000 X 28%). 3 Because of the at-risk rules, Amanda's tax deduction in year 1 is limited to her at-risk basis of $40,000. The $8,000 loss that is not deductible in year 1 is suspended until her at-risk basis increases. Therefore, her tax benefit from the deduction is $11,200 ($40,000 X 28%). 4 Amanda's $32,000 share of income increases her at-risk basis and provides the opportunity to claim the $8,000 suspended loss from the previous year. Therefore, her taxable income from this investment in year 2 is $24,000 ($32,000 - $8,000) and the tax due is $6,720 ($24,000 X 28%). pp. 5-18 and 5-19 15. In 1999, Kay cannot deduct any of the passive loss. The $35,000 loss is suspended and carried forward to 2000. The 2000 income of $15,000 is reduced by $15,000 of the suspended passive loss from 1999. After deducting $15,000 of the passive loss in 2000, $20,000 of the 1999 passive loss remains suspended. pp. 5-20 to 5-23 16. Option B's benefit exceeds Option A's by $7,225 ($21,451 - $14,226), primarily because of the flow of the benefits and the ability to benefit from the passive loss deductions in years 1 and 2. Option A Income Yr. 1 $8,000 Yr. 2 8,000 Yr. 3 8,000 Total present value Tax cost/ benefit After-tax benefit 8% PV factor Present value ($2,480) (2,480) (2,480) $5,520 5,520 5,520 0.92593 0.85734 0.79383 $ 5,111 4,733 4,382 $14,226 Tax cost/ benefit After-tax benefit 8% PV factor Present value $ 2,480 620 23,460 0.92593 0.85734 0.79383 $ 2,296 532 18,623 $21,451 Option B Income Yr. 1 ($ 8,000) Yr. 2 (2,000) Yr. 3 34,000 Total present value pp. 5-18 and 5-19 $ 2,480 620 (10,540) 5-10 17. The $50,000 loss is suspended under the passive loss rules because Ray is not a material participant. AGI is $140,000. pp. 5-18 and 5-19 18. Last year, Leanne could deduct nothing against nonpassive income, and was required to allocate the $40,000 net loss among the three loss activities. Income (loss): Activity A Activity B Activity C Activity D Net passive loss $10,000 (5,000) (25,000) (20,000) ($40,000) Net passive loss allocated to: Activity B (5/50 X $40,000) Activity C (25/50 X $40,000) Activity D (20/50 X $40,000) Total suspended losses ($ 4,000) (20,000) (16,000) ($40,000) In the current year, Leanne has a net gain of $19,000 from the sale of Activity D. She can offset the $16,000 suspended loss from the activity and the current year's loss of $1,000 from the activity against the $19,000 gain. In addition, the remaining net gain of $2,000 ($19,000 - $16,000 - $1,000) from the sale may be used to absorb passive losses from other activities. Examples 25 and 26 19. a. Net sales price Less: Adjusted basis Total gain Less: Suspended losses Taxable gain (passive) $100,000 ( 35,000) $ 65,000 ( 40,000) $ 25,000 b. Net sales price Less: Adjusted basis Total gain Less: Suspended losses Deductible loss $100,000 ( 75,000) $ 25,000 ( 40,000) ($ 15,000) c. Net sales price Less: Adjusted basis Total gain Less: Suspended losses Deductible loss $100,000 ( 75,000) $ 25,000 ( 40,000) ($ 15,000) The suspended passive losses are fully deductible. The suspended credits are lost forever because the sale of the activity did not generate any tax. pp. 5-20 to 5-22 and Example 28 20. A personal service corporation cannot offset passive losses against active or portfolio income. Brown’s income is $560,000 ($500,000 active income + $60,000 dividend income). Example 30 and related discussion 21. a. A personal service corporation is not allowed to offset passive losses against ordinary income. Therefore, White's taxable income based on the facts given is Losses and Loss Limitations 5-11 $436,000 ($400,000 income from operations + $36,000 portfolio income). Example 30 b. 22. A closely held, non-personal service corporation is allowed to offset passive losses against active income, but not against portfolio income. Therefore, White's taxable income based on the facts given is $396,000 ($400,000 income from operations $40,000 passive loss + $36,000 portfolio income). Example 31 A closely held, non-personal service corporation can offset passive losses against active income, but not against portfolio income. Green's income is $60,000 ($50,000 active income + $60,000 dividend income - $50,000 passive loss deducted to extent of active income). Green will have a suspended passive loss of $30,000 ($80,000 - $50,000 used). Example 31 23. Smith, Raabe, and Maloney, CPAs 5101 Madison Road Cincinnati, Ohio 45227 December 5, 2000 Mr. Greg Horne 431 Maple Avenue Cincinnati, OH 45229 Dear Greg: This letter is in response to your inquiry regarding the various strategies that are available concerning your movie theater and drugstore ventures in Cincinnati, Indianapolis, and Louisville. As you know, the basic issue relates to how the stores should be grouped or reported under the passive activity rules so as to maximize the tax benefit. As things currently stand and based on the projections that you have provided for the year, the $400,000 salary from your radio show is active income. If you do not participate any more in any of the movie theater or drugstore businesses, all profits and losses will be passive. As a result, you would have a net passive loss of $55,000 ($89,000 loss + $41,000 loss + $15,000 loss - $56,000 profit - $34,000 profit) that would be suspended and not available to offset your salary. To mitigate this result, three options are available. Option 1 is based on the significant participation activity rule. If all of the businesses were treated as separate activities, you would not be considered a material participant. Under the significant participation activity rules, the drugstores would be considered significant activities, but the movie theaters would not. Even with the drugstores, the total participation is not expected to exceed the more-than-500 hour threshold (140 + 170 + 180 = 490). Therefore, if you could participate 11 more hours in any of the drugstore businesses, they would be treated as active. You then could offset the net loss from the drugstores of $145,000 ($89,000 + $41,000 + $15,000) against your salary. Further, if you do not participate any more in the other theater businesses, their combined $90,000 of income will be reported as passive income. This characterization as passive could be helpful if you were to acquire additional passive businesses in the future that produce passive losses. Under option 2, both the movie theater and drugstore businesses could be combined as a “single activity” based on common ownership. Because you have participated more than 500 hours in the five businesses, the net loss of $55,000 would be considered active and 5-12 could be used to offset the salary. Based on product, option 3 would combine the drugstores as one activity and the theaters would be treated as a separate activity. As with option 1, if you could participate 11 more hours in any of the drugstore businesses, they would be treated as active and you could offset the net loss of $145,000 ($89,000 + $41,000 + $15,000) against your salary. Also, you could treat the theaters as a single business and the net income would be passive. This could be helpful in the future if other passive ventures would be acquired. Other grouping possibilities exist, such as a grouping by location, but they do not appear to produce any tax advantages. Before making a decision on the above options, you should consider what is likely to happen in the future. For example, what is the likely profit and loss pattern of the existing businesses? Will you acquire additional businesses? If so, what types of businesses are likely to be acquired, and how will the new businesses fit into the grouping method that you adopt? Will you dispose of any of the existing businesses in the near future, and what impact will that have on the current grouping decisions? You will need to consider carefully all tax factors in deciding how to group your activities. This is so because once activities have been grouped, they cannot be regrouped unless the original grouping was clearly inappropriate or there has been a material change in facts and circumstances. Of course, our firm will be happy to assist you further in anyway we can concerning the choices you face. If we can answer or clarify any questions you may have, please call me. Sincerely, John J. Reswick, CPA Partner pp. 5-25 to 5-28 24. 25. • The amount of Rene’s at-risk basis in the hardware business and whether the losses flowing from the entity are limited by the at-risk rules. • Whether the profits and losses from the public accounting firm are classified as passive or active. • Whether Rene is a material participant in the hardware business. • Whether Rene is subject to the passive loss rules. pp. 5-16 to 5-30 Smith, Raabe, and Maloney, CPAs 5101 Madison Road Cincinnati, Ohio 45227 January 23, 2000 Mr. John Jay 123 Baskerville Mill Road McKenney, Virginia 23872 Losses and Loss Limitations 5-13 Dear John: This letter is in response to your request for assistance in analyzing the tax consequences resulting from two investment alternatives. One alternative is to make an additional investment of $10,000 in Rocky Road Adventures in which you have an at-risk basis of $0, suspended losses under the at-risk rules of $7,000, and suspended passive losses of $1,000. If you were to make this investment, your share of the expected profits this year would be $8,000, while if your investment stayed at the same level, your share of profits would be $1,000. Your other choice is to invest $10,000 as a limited partner in the Ragged Mountain Winery, which would produce passive income of $9,000 this year. I have prepared the following analysis based on these facts. Invest $10,000 in Rocky Road Adventures: Expected profit from investment Beginning at-risk basis Increase to at-risk basis due to investment Use of loss suspended by at-risk rules Ending at-risk basis Beginning suspended passive loss Reclassified suspended passive loss Use of suspended passive losses—revised Current taxable income Current tax liability $ $8,000 -010,000 $10,000 (7,000) $ 3,000 ($ 1,000) ( 7,000) Invest $10,000 in Ragged Mountain Winery: Expected profit from investment—Ragged Mountain Winery Expected profit from investment—Rocky Road Adventures Use of suspended passive losses from Rocky Road Adventures Current taxable income Current tax liability ($9,000 X 31%) $ $ (8,000) -0-0$9,000 1,000 (1,000) $9,000 $2,790 As you can see, the tax effects of the two options vary significantly and the differences relate to the interplay of the at-risk rules and the passive activity loss rules. I hope that this analysis will help you make a more informed investment decision. If you need any further explanation, please contact me. Sincerely, Libba Eanes, CPA Partner Examples 44 to 47 26. Lee’s share of ABC’s loss in 2000 is $80,000 ($400,000 X .20 ownership interest), and the entire loss is suspended under the passive loss rules. His share of the passive income in 2001 is $40,000 ($200,000 X .20 ownership interest). His at-risk amount is $80,000 ($120,000 - $80,000 passive loss in 2000 + $40,000 share of income in 2001). In 2001, he may deduct $40,000 of his $80,000 suspended loss against the passive income. This leaves a $40,000 suspended loss at the end of 2001. pp. 5-30 to 5-32 27. Fran is a material participant, so the passive loss limits do not apply. The at-risk rules limit Fran's prior year deduction to $40,000, the amount she is at risk. This reduces her at-risk amount to $0 ($40,000 at-risk amount - $40,000 deduction). The remaining $10,000 is 5-14 suspended under the at-risk limits. The current income increases Fran's at-risk amount to $30,000 ($0 beginning balance + $30,000 income). This will enable her to deduct the $10,000 loss from last year that was suspended under the at-risk limits. Her at-risk amount at the end of the current year is $20,000 ($30,000 - $10,000 deduction for the prior year loss). pp. 5-18 and 5-19 28. a. Initially the remaining $15,000 is disallowed by the at-risk limits. Since Soong is not a material participant, $45,000 of his $60,000 loss is reclassified as a passive loss and disallowed under the passive loss limits. Therefore, Soong's AGI is $218,000 ($200,000 salary + $18,000 portfolio income). b. Initially the remaining $15,000 is disallowed by the at-risk limits. Since Soong is a material participant, $45,000 of his $60,000 loss is deductible as an active loss. Therefore, Soong's AGI is $173,000 ($200,000 salary + $18,000 portfolio income $45,000 active loss). Examples 44 to 47 29. The fundamental issue is how can the time that Alan devotes to his business best be allocated across the various businesses in order to minimize the negative impact of the material participation rules as set out in the Regulations. Related to this issue are several points that need to be identified and resolved. • How are the various businesses grouped together to form activities and how many hours does Alan spend working in each activity? • How many employees are working at each of the businesses and how many hours have they worked? • What type of work can Alan’s wife do to ensure that her participation will be treated as being his? • Whether Alan is a limited partner in any of the businesses (which would allow for applying the rules in a different way). pp. 5-25 to 5-29 30. If losses were limited only by the at-risk rules, Sam would be able to deduct the following amounts in 1999 and 2000. Year Loss Allowed* Disallowed 1999 2000 $40,000 $30,000 $10,000 30,000 -030,000 $70,000 $30,000 $40,000 *Allowed under the at-risk rules, then reclassified as passive losses and subject to the passive loss limitations. However, the losses are limited by the passive loss rules as follows: Year Passive 1999 2000 $30,000 -0$30,000 Deductible $-0-0$-0- Suspended $30,000 -0$30,000 Losses and Loss Limitations 5-15 In 2001, the $50,000 income increases Sam's at-risk amount to $50,000 so he is allowed to deduct the $40,000 of disallowed losses in 2001. The $50,000 is passive income which can be offset by $30,000 of suspended losses, leaving a suspended loss of $20,000. At the end of 2001, Sam has no unused losses under the at-risk rules, $20,000 of suspended passive losses and a $10,000 adjusted basis in the activity ($30,000 adjusted basis on 1/1/99 $40,000 loss in 1999 - $30,000 loss in 2000 + $50,000 income in 2001). Examples 21 and 44 to 47 31. Smith, Raabe, and Maloney, CPAs 5101 Madison Road Cincinnati, Ohio 45227 March 5, 2000 Mr. Joe Cook 125 Hill Street Charleston, WV 25311 Dear Mr. Cook: This letter is in response to your inquiry regarding the $50,000 loss you incurred this year in conjunction with your investment in the apartment building, which I have assumed is not low-income housing given that it is located in an exclusive part of the city. As I understand your situation, you anticipate that your current AGI, exclusive of the loss flowing from the real estate rental activity, will be $140,000 and you wish to determine whether the loss is either partially or fully deductible. As you are aware, the apartment rental activity is considered a passive activity, and, in general, is subject to the passive activity rules. However, because you are an active participant in the investment, you will be able to deduct $5,000 under a real estate rental exception to the passive activity rules. More specifically, the law allows losses of up to $25,000 from certain real estate rental activities to be deducted each year. However, if a taxpayer's AGI exceeds $100,000, the amount deductible in the current year is reduced by 50% of every dollar of AGI over $100,000. Once a taxpayer's AGI reaches $150,000, no current loss deduction is allowed. Because your AGI is expected to be $140,000, the maximum allowable loss of $25,000 is reduced as follows: [$25,000 (maximum allowable) - .50($140,000 AGI - $100,000)]. Therefore, your AGI would be $135,000 after the allowable $5,000 loss ($140,000 - $5,000). The remaining $45,000 loss that would not be deductible in the current year is suspended under the passive loss rules and would be available in future years. If you do not actively participate in this activity next year, and a loss is generated, none of it will be deductible under the real estate rental exception. Joe, if you have any additional questions or would like further clarification of this matter, please call me. Sincerely, John J. Jones, CPA pp. 5-32 to 5-34 32. Donald does not satisfy both requirements for certain real estate professionals that allow nonpassive treatment for losses. Of the 2,300 hours Donald worked during the year, only 5-16 1,100 hours, or less than half, involved real estate trades or businesses in which he materially participated. Therefore, his real estate rental activities are passive activities. However, the 600 hours Donald devoted to his real estate development business satisfies the 500-hour material participation requirement. Therefore, the $18,000 loss is fully deductible. Under the rental real estate exception, Donald can deduct $25,000 of his $26,000 of losses. The remaining $1,000 of losses are suspended passive losses. pp. 5-32 to 5-34 33. Smith, Raabe, and Maloney, CPAs 5101 Madison Road Cincinnati, Ohio 45227 December 15, 2000 Scott Myers 603 Pittsfield Dr. Champaign, IL 61821 Dear Scott, Based on our discussion, I understand that you are attempting to qualify under the special rules for real estate professionals as a material participant in order to deduct against your nonpassive income any losses generated by this rental activity. Consequently, you should document a sufficient number of hours so that you will meet the material participation standard. Your activities to date appear to be within the bounds of the tax law as it is written, but you also appear to be stretching its limits. You need to be careful to avoid any appearance of or taking any actual fraudulent actions on you or your wife’s part. Essentially, the issue is whether the participation hours generated are of substance or merely of form. Another issue is whether one of the principal purposes of the tasks being performed is to avoid the disallowance of passive losses or credits. Should you need more information or need me to clarify anything, please call. Sincerely, Jake Smith, CPA p. 5-33 34. Roger is a material participant in the tax practice but not in the real estate development activity, which causes the real estate development to be classified as passive. Further, the apartment leasing operation is a passive activity because it is a rental activity and it does not qualify for the real estate rental exception given the taxpayers’ level of income. Therefore, the income from the tax practice may not be offset by either the losses from the real estate development business or the apartment leasing operation. Losses and Loss Limitations 5-17 Roger does not qualify for the exception for real estate professionals because he has not spent more than half of his personal services in real estate trades or businesses in which he materially participates. He has not been a material participant in the real estate development activity (i.e., he has not spent more than 500 hours in the activity); therefore, the resulting loss is treated as a passive loss. Further, he does not qualify for the limited $25,000 exception available for rental real estate activities for the apartment leasing operation because his joint income tax return will show AGI in excess of $150,000. pp. 5-32, 5-33, and Example 49 35. Gene is considered a material participant in the tax practice but not in the apartment leasing operation. However, because he actively participates in the real estate rental activity and owns at least 10% in the activity, $25,000 of the $30,000 loss is deductible in the current year against his tax practice income. The remaining $5,000 loss from the rental activity is suspended as a passive activity loss. pp. 5-32 and 5-33 36. How Active is Active? Under the real estate rental activities exception, George and Louise qualify to deduct a loss of up to $25,000 from the real estate rental activity if they actively participate in the activity and own a 10 percent or more interest in the activity. Here the issue is whether their involvement has reached the level of active participation for the year. In general, being an active participant requires the owner to make management decisions in a significant and bona fide sense. The facts revealed in the scenario suggest that they have taken a “hands off” approach and have left most, if not all, of the management decisions to the property manager. Nonetheless, the tax preparer servicing George and Louise should inquire more about the role that they actually played in the operations of the rental unit to be certain about their level of participation. For example, perhaps they actually were involved in making key management decisions such as approving new tenants, deciding on rental terms, and approving capital or repair expenditures. Such involvement would be enough for them to be considered active participants. However, given that George and Louise are surprised that a loss resulted from the operations, they may not have envisioned the need to actively participate. Therefore, unless additional supporting evidence comes to light, claiming a deduction under the real estate rental activities exception does not appear to be supported by the facts of the scenario by virtue of their lack of participation. 37. Ida can utilize $20,000 of losses and $1,400 of credits as follows. Income (Loss): Net loss Utilized loss Suspended loss Utilized credit Suspended credit Activity A Activity B Activity C ($12,000) (18,000) 10,000 ($20,000) 20,000 $ -0$ 1,400 $ 700 After deducting the loss of $20,000, Ida has available a deduction equivalent of $5,000 [$25,000 (maximum loss allowed) - $20,000 (utilized loss)]. The maximum amount of credits Ida may claim is $1,400 [$5,000 (deduction equivalent) x .28 (marginal tax bracket)] that is allocated to Activity A. Examples 49 and 50 38. Rental loss ($105,000) 5-18 Rental income Other passive income Net passive rental loss Deductible against other income Suspended rental loss Example 49 25,000 32,000 ($ 48,000) 25,000 ($ 23,000) Losses and Loss Limitations 5-19 RESEARCH PROBLEMS 1. Smith, Raabe, and Maloney, CPAs 5101 Madison Road Cincinnati, OH 45227 February 2, 2000 Mr. George Johnson 100 Apple Lane St. Paul, Minnesota 55123 Dear Mr. Johnson: This letter is in response to your request concerning whether you can claim a casualty loss for the damage your automobile sustained when it fell through the ice as you were watching an iceboat race. Based on our research, we believe that the event constitutes a casualty and as such, you are entitled to claim a casualty loss for the damage to your car. Should you need more information or need further clarification on any matter, do not hesitate to contact me. Sincerely yours, John J. Jones, CPA Partner TAX FILE MEMORANDUM January 29, 2000 FROM: John J. Jones SUBJECT: George Johnson’s Casualty Loss Today I talked with George Johnson concerning an incident involving his car. Several weeks ago, George parked his car on a lake while he was watching an iceboat race. During the race, the ice beneath his car unexpectedly gave way, and the car sank to the bottom of the lake. George wants to know whether he will be entitled to claim a casualty loss for the damage to his car. The facts of George’s case are similar to Rev. Rul. 69-88, 1969-1 C.B. 58. In the ruling, the taxpayer’s automobile was parked on the ice while he was ice fishing. A casualty loss was allowed for the purpose of claiming a deduction under § 165. 5-20 Based on this ruling, I have advised George that he will be entitled to claim a casualty loss for the damage to his car. 2. John and Samantha’s plan to generate rent income that would then be offset by otherwise suspended passive losses is very creative. Unfortunately for John and Samantha, however, Reg. § 1.469-2(f)(6) holds otherwise. If property is rented to a nonpassive activity, such as John’s medical practice, then such gross rent income generated is treated as though it is not from a passive activity if the property is used in a trade or business activity in which the taxpayer materially participates. This Regulation would essentially eliminate the benefits that John and Samantha desire by treating the rent income as active income rather than passive. In a case involving an attorney whose law practice rented a building owned by the attorney and his wife, the validity of Reg. § 1.469-2(f)(6) was reviewed by a court. [Fransen v. U.S., 98-2 USTC ¶50,776, 82 AFTR 2d 98-6621 (D.Ct. La., 1998), affd. in 99-2 USTC ¶50,882, 84 AFTR 2d 99-6360, 191 F.3d. 599 (CA-5, 1999)]. The Court concluded that the Regulation is valid, in a fact pattern that is similar to John and Samantha’s. The IRS properly recharacterized as non-passive the attorney and wife's income from the rental activity. The income was treated as nonpassive because the building was rented by a trade or business (i.e., his law firm) in which he materially participated. The statute, legislative history, and the Regulation’s rationale showed that the Regulation did not arbitrarily negate § 469’s classification of rental activity as passive. 3. Assuming George and Judy can show that they are carrying on the chartering activity for profit (i.e., it is not a hobby), any losses resulting from the activity would be considered passive unless they can show that they are materially participating in the chartering venture. They have obviously not met the more than 500-hour standard of material participation. However, Temp. Reg. § 1.469-5T(a)(3) provides that if the taxpayer participates in an activity for more than 100 hours (but not more than 500 hours), the material participation standard is met if the taxpayer’s participation is equal to or more than any other individual involved in the venture. In this case, such other individual is Captain Mac. Thus, based on this test, George and Judy would be required to devote more hours in the activity than Captain Mac to be considered material participants. In all probability, Captain Mac has devoted more than 120 hours during the course of a rental season given the scope of his duties. Unless George and Judy can show that their level of participation is at least equal to Captain Mac’s, their efforts would be considered insubstantial and not at a level of material participation. Therefore, any losses resulting from this chartering activity would be treated as passive. See Thomas C. Oberle, et ux. v. Commissioner (T.C. Memo. 1998-156, 75 TCM 2204) where the Tax Court ruled in similar fashion in a fact pattern like George and Judy’s. In addition, see William A. Goshorn (T.C. Memo. 1993-578, 66 TCM 1499) and Chapin, B. Theodore (T.C. Memo. 1996-56, 71 TCM 2027). 4. The Internet Activity research problems require that the student access various sites on the Internet. Thus, each student’s solution likely will vary from that of the others. Losses and Loss Limitations 5-21 You should determine the skill and experience levels of the students before making the assignment, coaching them where necessary so as to broaden the scope of the exercise to the entire available electronic world. Make certain that you encourage students to explore all parts of the World Wide Web in this process, including the key tax sites, but also information found through the web sites of newspapers, magazines, businesses, tax professionals, government agencies, political outlets, and so on. They should work with Internet resources other than the Web as well, including newsgroups and other interest-oriented lists. Build interaction into the exercise wherever possible, asking the student to send and receive e-mail in a professional and responsible manner. 5. See the Internet Activity comment above.